Monday, February 1, 2021

Hello, World!

Popping my head above water for the first time in a while in an attempt to hold my feet to the fire -- at least when it comes to my retail portfolio.  

In 2020 *I believe* my investments appreciated a little over 15%.  Seeing as I started buying right after the March crater, it'd be hard to do worse.  I learned three things: (1) don't be under invested; (2) don't be over diversified; and (3) do your own due diligence before investing.  Fundamental and boring lessons they may be, but for me they had to be earned to be learned.  

So, going forward, this blog will chronicle my personal investments in my retail account.  Keeping those lessons in mind, I will strive to be fully invested at all times, heavily concentrated, and firm in my convictions.  At the end of ten years (yes I am a believer that decades start off odd and end even), my goal is to have an average CAGR of 20%.  While clearly a tall task, I at least made the math a little easier for myself by leveling out my account to $10,000 to start out the new year.  I will neither deposit nor withdraw anything from this account and I will pay taxes on the gains (if there are any) out of my own pocket.  All this should make keeping track of my progress simple enough.

What's the point of doing this?  What could be cooler than calling your shot 119 months in advance to the rapt attention of the two Chinese teenagers and fourteen bots that follow my blog?!  Well, for starters, $61k may be enough for first and last month's rent in 2030 for a studio in Charlestown.  If it's not, then this is me from the past telling you to buy that land in Wyoming you've always dreamed about.  The benchmark is arbitrary but it seems much more concrete and satisfying than moving the goalposts every year with a 5% beat on the S&P.  More importantly, I don't care how well everyone else is doing.  This venture is not a vanity project where I brag about my big bets or compare my gains to others; I want to learn how to accurately value businesses and profit off that knowledge.  If the recent hysteria around GME et al. has taught me anything it's that the wisdom of the crowd means nothing when the crowd is full of idiots.  Call me a retard all you want, but I'd rather lose money in a well-reasoned venture than win the lottery because an autist from WSB gave me the winning numbers. 

Friday, June 12, 2020

Friday 5ish

These are fascinating times.  Trying to strike a balance among the triad of market news, COVID-19 updates, and BLM think pieces is becoming my full time job.  I have no idea how people with actual jobs stay on top of everything -- hopefully I find out for myself soon enough.

A benefit of this chaotic year is the education it enables if you have the opportunity to pay attention.  I've learned more in the past few months about market movements and macroeconomics than I had in the six years prior.

We've seen the largest number of cross-asset 3σ -- sigma defined as one-day move on 3m implied volume on previous day -- moves since 1998...and it's only June!  The oil crash, corona, and QE are the likely culprits for the volatility in volume, but I can't quite wrap my head around all the moves in fx.  The Renmibi, not shown in the chart, has made considerable strides as a percentage of reserves since 2015, but people I trust say there's no shot in hell that redbacks become the dominant currency.  Here's some good reading on it: 1 | 2 | 3 | 4 

In the meantime, here's an interesting take by The Economist on how the proposed corona bonds are an unlikely benefit of Brexit.

In a similar counterfactual in which I had actually posted a blog last Friday, here is a comprehensive report by the UN on the multitude of effects that the virus is having on the world.  Make some time for this on your weekend because it's required reading.

The world is now at 100k new cases of corona a day.  Texas, Florida, and Arizona, all early re-openers, are seeing record number of new cases.  Unfortunately, it's reasonable to expect similar numbers across the country with us being close to two weeks removed from other reopenings + protests (I'd be curious to see some statistics on new cases in police departments).  The Institute for Health Metrics and Evaluation projects 169,890 deaths by Oct. 1 (113,561 as of June 11).  Ashish Jha, director of the Harvard Global Health Institute, says there could be another 100k before September.  Read more here.

Imperative in the country's response is the management of public policy by our governors and mayors.  In my own state, Messrs. Cuomo and de Blasio have a lot to answer for.  Not mentioned in that article was the March 25th order that forced infected patients into nursing homes, a decision that alone cost thousands of lives.  Learn from your mistakes.

I find comfort in reading how other societies and cultures responded to moments like these, so I'll finish my Friday post with this piece on the Black Death's impact on Sienese art.  It's more interesting than it sounds.

Have a safe weekend.


Saturday, May 9, 2020

Friday 5

This is the first edition of my Friday 5, a collection of the five most interesting things I read or consumed during the week.  I've been developing a moderate case of content amnesia so this will be a place where I can aggregate links and gather my thoughts before I forget them all.  Hopefully those lost internet travelers that stumble upon my blog will find them interesting as well.

Starting off my weekly roundup is the announcement of the 2020 Pulitzer Prize Winners made on Monday.  The archive of previous Pulitzer winners has been an invaluable resource for when I've wanted to research certain topics or read up on recent events that passed me by, so I was happy to see Dominic Gates, Mike Baker, and Lewis Kamb of The Seattle Times win for their reporting on the design flaws in the Boeing 737 MAX.  I'm still picking my way through the list, but I look forward to reading one of the nonfiction winners, The End of the Myth: From the Frontier to the Border Wall in the Mind of America, in tandem with How to Hide an Empire: A History of the Greater United States, which has been burning a hole in my Kindle ever since I bought it.

Back to bombard you with more walls of text is the University of Toronto's Citizen Lab's fantastic report on the surveillance conducted by WeChat on content posted by users outside China.  "Yeah, no duh," you probably just thought - so did I.  Even for fervent China skeptics like me, this served as a reminder of Tencent and, by extension, CCP interference and monitoring of our daily lives.  It's very hard to go throughout your day on the internet without being monitored by an American corporation, but if you need a reason to stop using Chinese software or refrain from investing in a CCP-sponsored company - yes, I'm a hypocrite - this should wake up your dormant jingo gene.

In case you're already snoozing through this list, watch (or just listen - he's one of the smoothest public speakers I've seen) to Frank Abagnale, the real con-artist from Catch Me If You Can, give a surprisingly touching talk on his life and cybersecurity.

Wading into macro, I recommend sitting down and looking at this brief from Paul Jones and Lorenzo Giorgianni.  If you're one of those insufferable guys like me who had the opportunity to buy Bitcoin years ago and didn't but never shuts up about it, or if you're that other guy who scoffs at the mere idea of cryptocurrency, or if you're someone who hasn't managed to identify with the two very specific stereotypes I just made, give this one a glance.

Closing out this week is a look into the wacky world of university finance.  The Grumpy Economist gave us some insights into the kind of exposure colleges have going into this economic downturn, specifically the hit in expected tuition fees.  I was surprised at how illiquid some of the big-name endowments really are, and I'm curious to see where my alma mater stands in this regard. 

Have a good weekend and send love to your mom.

Monday, May 4, 2020

Coda Octopus Group (CODA)

Coda Octopus (CODA) is an overlooked small cap that designs, manufactures, and sells solutions for the subsea market.  As the company operates in a narrow industry and has no analyst coverage to speak of, its unique technology, profitability, and potential acquisition are not accurately reflected in the share price.  Trading at 2.5x recurring revenue and a historical low 7.4xEBITDA, CODA is a strong long term buy.

Company Overview 
Coda Octopus began as Coda Technologies, a UK corporation formed in 1994 to develop software for subsea mapping.  In 2002, the company acquired OmniTech As, a Norwegian firm, and shifted much of its operations into developing the acquired sonar technology of a “method for producing a 3-D image," the predecessor of the flagship product it offers today.  The company has been headquartered in Florida after a reverse merger in 2004 with The Panda Project, Inc.  Prior to 2017, CODA was being traded OTC and had not filed with the SEC since 2010 after voluntarily delisting under Section 12(g). 

CODA’s business is simple to understand.  The Marine Technology Business sells geophysical systems, motion and positioning systems, and Real Time Volumetric Imaging Sonar to various commercial entities operating in the subsea space.  The Marine Engineering Business offers similar solutions but to defense contractors and to the US and UK defense departments directly.  Over the past four years, the company has generated approximately 55% of revenue from the former.

Investment Thesis
A. Unique Technology

Real Time Volumetric Sonar (RTVS) is CODA’s proprietary technology and flagship product, developed inhouse over 25 years and currently the only such product on the market.  The advanced nature of this tech gives it a relatively wide moat and it is the company’s sole competitive advantage in the subsea imaging industry.  RTVS is sold as a hardware+software bundle.

The hardware, CODA’s proprietary Echoscope sonars, is sold, leased, or rented into every marine sector from offshore energy and renewables to commercial fisheries.  The company completed launch on its 4th generation sonars in late 2019 and expect to begin launch on its 5th gen sonars in 2020.  Among other advancements such as smaller frames and less power consumption, the iterative generations of sonar hardware relate to their compatibility with CODA’s 3D sonar software.

Native to this hardware is the company’s Real-Time 3D (4D) volumetric imaging sonar system.  While competitors offer basic sonar imaging on XYZ axes, CODA’s Underwater Survey Explorer (USE) software has the following unique capabilities:
  • Live 3D imaging of any moving objects within the sonar field of view including construction assets, divers, subsea vehicles and tools and machinery executing tasks underwater.
  • Accurate three-dimensional data unaffected by motion or water visibility.
  • Mapping of complex structures with a volumetric ping as opposed to individual angular slices of data. The more complex the structure, the greater the benefit of real-time volumetric sonar imaging over a traditional survey.
  • Live situational awareness of static and moving objects for safe terrain navigation or target tracking.
  • First Person Perspective imaging allowing the operator to point the real-time volumetric imaging sonar towards any target, regardless of where in the water column the target is located and generate a true image first person perspective image.
  • Imaging or visualizing subsea environments in low or zero visibility conditions and in situations of high waterflow and active noise pollution (dredging and rock dumping).
  • 3D Range gating of the live image to focus on specific targets or features at specified ranges – regardless of signal strength. This specifically allows for weak targets close to the sonar to be discarded from the image (e.g. bubbles or fish) or detected as threats (e.g. fishing nets).
  • Coherent single sensor delivery for multiple applications.
  • Unique rendering and viewing software techniques that simplifies data interpretation.
  • Direct integration with a range of compatible sensors (e.g. GPS, attitude sensors), actuators (pan, tilt) and custom, task-specific software that provides task or mission solutions for key markets such as the underwater construction market and offshore wind energy sector.
That list is taken directly from the company’s 10-k and, unless you have extensive experience in the demands of the subsea imaging space, its contents mean close to nothing to you.  After a few too many hours researching this industry and CODA’s competitors, I’m still forced to take much of this jargon at face value.  However, after talking to some people in the industry, it is clear that the Echoscope+USE is both necessary and a cost-saving product in the deep-sea construction business.  Furthermore, the rollout of the smaller and lighter 4th gen Echoscope Surface in 2019 paved the way for CODA to consolidate a greater market share in subsea operations as it was specifically designed for small autonomous surface vehicles.  The planned rollout in 2020 and 2021 of 5D and 6D abilities to USE, backward compatible with previous gen Echoscopes, give CODA the clear upper hand in technology over any other product on the market while its absolute pricing power in the deep-sea business afford the opportunity to set subsea offerings at competitive prices. 

CODA’s geophysical systems and motion and positioning systems make up the other 10% of the Marine Technology Business and operate in a fragmented industry where it controls maybe 5% of world-wide sales.  The only room for growth in this industry is by packaging these products with RTVS, which the company is currently doing with its motion and positioning systems.

B. Profitability

CODA’s aforementioned pricing power has translated to an outstanding 79% gross margin in its Marine Technology Business over the last four years.  This has been accompanied by a steady 4% CAGR in revenue from 2016-2018.  Revenue from this segment increased 13% in 2019 on the back of the rollout of the 4th gen Echoscope+USE.  If not for COVID-19, revenues from this segment would have been expected to grow ~10% on the back of the 4th gen and future software develops plus a sharper focus on marketing. 

The company’s Marine Engineering Business is the wildcard.  Offering services and solutions to defense departments and contractors, the segment generated $12M in revenue last year – a 79% increase from the 2017-2018 average and 49% of total revenue.  This revenue stream has been cyclical for the past decade; any delay in passing of the federal defense budget will affect the contracts and deliverables won by CODA, compounded by its odd fiscal year end of October 31.  Even though the dramatic growth in FY2019 revenue can be attributed to the company catching up on backlog, the engineering business stands to increase annual revenue for two reasons:
  1. Besides the rollout of its 4th and 5th gen products in the coming year, CODA has two new products coming to market in 2020: Thermite Octal and Diver Augmented Vision Display (DAVD).  Thermite Octal is the next generation of Thermite Rugged Visual Computers currently used by the US Army for, among other things, dismounted soldier training, robotic control, and weapon system control.  The new Thermite Octal, designed for military helicopters and tilt-rotor aircraft, has completed the first article inspection approval phase and is now in the production phase.  CODA expects this product line to add $3-$7M to annual revenue.  The DAVD looks like it is straight out of a David Cameron 20,000 Leagues Under the Sea passion project – it provides a real time 3d image to the diver that is also shared with a surface supervisor.  The company is introducing DAVD into the Navy fleet this year and has used its collaboration with the Navy to get a number of its sonars on the Authorized for Navy Use list. 
  2. Captain J. Charles Plumb was added to the board of directors in September 2019.  Cpt. Plumb has an inspiring story as a POW and chaplain in Vietnam – I recommend searching for one of his talks on YouTube – and has served on the BoD of the Lightspeed Aviation Foundation.  CODA flat out states that he was added “because of his close ties to the U.S. Defense establishment” which clearly signals its increased focus on growing revenue from its servicing business. 
Despite the cyclical nature of the marine engineering segment, the recurring revenue streams from defense contracting work and promise of growth from new products provide a foundation of sales that should make up at least 40% of total revenue going forward.  While the higher cost of sales (~50%) will never match the gross margin from the products segment, the revenue streams are less likely to be as heavily impacted by the economic downturn from COVID-19.

The decline in oil and gas prices in 2014 had severe adverse effects on CODA’s products segments which at the time generated the vast majority of its revenues from the O&G sector.  As a result, CODA had to shift its sales to other sectors and only 7% of Marine Technology Business revenues emanate from O&G.  Unfortunately, the company’s insulation from the O&G sector does not extend to the rest of its customers: most of sales generation for the products business requires international and offshore travel.  Historically, only 20% of products sales come from the Americas – contrasted with 90% of services sales – with the majority coming from Europe and Australia/Asia.  Q2 results should shed light on the extent of the downturn and provide a baseline for what to expect for the next few quarters going forward.  This constitutes the biggest risk to this investment in the short term.

The company’s only debt is a secured note to HSBC which expires in early 2022, the balance of which is approximately $940k as of Q1.  CODA has credit lines with HSBC of $4.5M which has not yet been drawn on and should not be needed as the company has sufficient cash reserves and working capital to fund its operations.  Even if it does make use of its credit lines, the company’s current ratio of 6.8 and debt to equity ratio of 0.03 are more than healthy enough to stomach some debt.  The accumulated deficit of $25M is not concerning as it has been steadily decreasing since 2011. 

If you annualize CODA’s Q1 earnings, you get an EPS of $0.52 before accounting for any of its $3.4M in NOL carryforwards.  It has just started producing consistent cash flow and was on pace to match last year’s EBITDA of $7.1M.  The economic downturn will erase sales from the products business, without a doubt, but if revenues grow at a 5% CAGR over the next five years you’re looking at a company that is being valued by the market at a 50% discount.

C. Potential Acquisition

In the realm of 3D underwater imaging, CODA has no real competitors.  However, in recent years, Teledyne Technologies has been rapidly expanding its Marine Group.  Teledyne’s most profitable business segment, Instrumentation, can trace $450M in revenue, 35% of total segment sales, to its marine business.  According to Teledyne:
Our strategy continues to emphasize growth in our core markets of instrumentation, digital imaging, aerospace and defense electronics and engineered systems. Our core markets are characterized by high barriers to entry and include specialized products and services not likely to be commoditized. We intend to strengthen and expand our core businesses with targeted acquisitions and through product development.
Since 2012, Teledyne has acquired eleven companies in the marine and subsea industry.  Four of these were direct competitors to CODA.  Out of the eleven, the only public company acquired was Bolt Technology, a marine seismic data business which Teledyne acquired for a $22/share, a 37% premium.  Revenue from the Marine Group has decreased over the last few years, and while Teledyne is holding a considerable amount of debt at the moment, acquiring CODA is very plausible given its synergies and advanced technology.  CODA’s public float is only 40% so its beneficial owners would stand to make a pretty penny.

If you’re a longer term investor, the only risk with this investment is an extended economic downturn and the ever present foreign currency exchange adjustment – close to 50% of CODA revenue is made in UKP.  Your margin of safety will be highest if you wait until Q2 earnings release: historically, the only major moves in the stock comes after a earnings are released.  With Q2 earnings expected to be depressed, I'm betting the price to drop close to $5.  Look for CODA to reach $12 by the end of 2022, if not sooner.  

Wednesday, April 15, 2020

Doomsday Prepping

After falling 32% from its high in mid-February, the S&P posted the best weekly gain in 45 years last Thursday.  Good old Goldman claims the market already reached its bottom, while simultaneously predicting Q2 GDP decline of 11% compared to 2019 Q2 and unemployment north of 15%.  Apparently the market has accurately priced in an economic downturn four times worse than the housing crisis?  Huh?  All I know for sure is I picked a helluva time to start taking a more active role in investing my savings.

Preferably, an intelligent value investor, professional or amateur, would have a shortlist of attractive businesses to invest in for times like these.  Unfortunately, I was unprepared.  Fortunately, I now have a lot of time on my hands.

I am a business analyst, not a stock analyst.  Whether this farce of a market continues to rise or ends up being a dead-cat bounce, I will continue to search for businesses worthy of investment.  Specifically, I'll be looking for:   
  1. a business built to weather and capable of growing in the current climate;
  2. strong - or a good promise of strong - cashflow;
  3. a healthy, liquid balance sheet;
  4. experienced and trustworthy management; and, as always,
  5. a sufficient discount to fair value.
This checklist is almost identical to my normal checklist for security analysis, with a few exceptions: chiefly, circle of competence and small-cap companies.  While I'll continue to look at under-valued micro- and small-cap companies with businesses that I can understand, I'd be a fool not to jump at blue chips trading at a large discount.  

I've already bought into Viacom at $12.50 and Amex at $74.  I recently took a small gamble on Antibe Therapeutics at $0.50 after being convinced by the report here and write-up here, and I've been gradually increasing my position in Avid Bioservices.  Besides that, I've increased my stakes in Hollysys and Coda Octopus (report pending) and took a small loss after selling my stocks in Vestas Wind Systems (bearish on their growth over the next two years due to economic downturn).

I'll be updating this feed on any future buys and sells.  I'll also include any companies I'm watching and I'll post reports on small-caps as I make them.  Once I build out this website I'll include a page that tracks my portfolio, gains, and losses.      

Thursday, February 20, 2020

The Selfish Implications of Coronavirus

Yesterday's release of Hollysys's 6-k for Q2 contained some pleasant surprises.  Revenue is on pace to match my 5% growth target, net income and EBITDA is projected to surpass my expectations, and they even addressed the countermeasures being taken to combat the coronavirus:
In response to the outbreak of the novel coronavirus, the Company has taken necessary actions to minimize the risk of spread of disease and adverse effects on the Company’s business operation. Since late January, we have been monitoring the health condition of our employees through on-going online survey. Starting from early February, we have been implementing a two-week-long work-from-home scheme. Meanwhile, we have set forth general rules of action for operation in each of our bases for precautionary purpose. For particular urgent projects covering R&D, production and engineering, staff has been requested for on-site work in accordance with the rules of action. Going further, we are planning to gradually resume on-site work with the staff density in our bases being prudently controlled. However the potential downturn brought by and the duration of the coronavirus is difficult to assess or predict where actual effects will depend on many factors beyond our control. We are closely monitoring its impact on us. Our business, results of operations, financial conditions and prospects could be adversely affected directly, as well as to the extent that the coronavirus harms the Chinese economy in general.
Hmmm. Look: I'm glad they addressed it. While an online survey may seem like the equivalent of using a periscope in the basement to check your kids for ticks as they play in the woods, the work-from-home and general operational effects disclaimer makes me feel a bit better.  At the very least, it's more comforting than the stifling reports coming from China.

Joshua Konstantinos over at Cassandra Capital has been a great job tracking the outbreak of COVID-19 and the misrepresentation of confirmed cases by the PRC.  It goes without saying that the market effects, and specifically the effects on HOLI's business, are hard to predict.  The corporate debt crisis in China, coupled with the nationalization of three banks last year, make me think China knows its got a leverage problem.  Even if China can replicate their SARS efforts against the coronavirus, the effects from months of lost labor and under consumption compared to 2003 should be...large.

As HOLI's customers are industrial in nature (with the exception of the small M&E division), its annual service revenue will drop from the stoppage of trains and plants.  Revenue from installations will drop as well, though most of these sales wont be lost in the traditional sense - just delayed. Bake in a drop in revenue due to quarantine and related virus effect from all divisions over the next two quarters (the company historically sees a drop in Q3 revenue from the Chinese New Year anyway). 

If you're still a fence-sitter, here are some additional reasons to be bullish over the long-term:
  • As of Q2, net assets are greater than the market capitalization of the company.  58% of NAV is in cash and marketable securities.  Smauging (can someone help me get a trademark for this) is much more common in Asian companies than in their American counterparts and after talks with management I'm hopeful this is a strategic play.  Either way, don't think too hard about this; cash reserves and cash generation is good.
  • Davis Funds recently increased their ownership in HOLI to over 10% of total shares outstanding.  I reached out to Danton Goei, portfolio manager of their Global and International funds, to share notes but haven't heard back yet.  Increase in ownership by a historically successful value-ish fund should convince some of you that this isn't totally out of right field.
  • With coronavirus dampening Chinese share prices, and Q3 numbers expected to drop, I expect HOLI shares to stay at a discount for the near future.  Good time to buy.
I'll be back in a few days to talk about Coda Octopus Group (CODA) - sounds more fun than "Hollysys" doesn't it?  In the meantime, read this.

Friday, February 14, 2020

Hollysys Automation Technologies (HOLI)

Hollysys Automation Technologies Ltd. (HOLI, the company) is a leading provider of automation and systems solutions in China, with overseas operations in eight other countries throughout Asia. The majority of its business is done in the industrial automation (IA) and rail transportation sectors, though it has low-margin operations in mechanical & electrical (M&E) and medical solutions as well. A miniscule debt-to-equity ratio, healthy historical cash flows, promising growth based on planned expansion in relevant sectors, and the Great Wall of China doubling as an economic moat all suggest taking a long position while the stock price hovers near its 52-week low.

Business Profile
Founded in 1993 and listed on NASDAQ since 2008, HOLI has grown from research team specializing in automation control in the power industry to a multinational company with customers in sectors including power, petrochemical, high-speed rail, and urban rail. In IA, HOLI provides automation hardware, software, and services spanning field devices, control systems, enterprise manufacturing management and cloud-based applications. In rail transportation, it provides advanced signaling control and supervisory control and data acquisition (SCADA) systems for high-speed rail and urban rail.

HOLI designs and manufactures all its products in-house at its facilities in Beijing and Hangzhou. Its core hardware is a printed circuit board, manufactured and assembled at the two Chinese facilities. Raw materials include bare printed circuit boards and various electronic components needed for assembly.

Approximately 82% of the company’s total consolidated revenues are derived from integrated solutions contracts won through the bid process. The remainder of revenue is generated through sales of spare parts, maintenance, and training services after the warranty period from the contracts has ended.

Ok, I kind of get it. So why should I be interested?
  1. A Strong Balance Sheet: After paying off its 20M convertible bond in Q1 of FY20, the company has total debt of only 2.5M. That’s good for a D/E ratio of 0.003, quite a bit lower than the 0.557 average of its competitors. It’s average OCF margin over the last three years is 19%, well above industry averages, and its average CFO/NI ratio over the same period is 0.99.
  2. Urbanization: Rapid industrialization and warped demographics has manifested in dramatic urbanization and economic integration, which in turn creates a critical need for infrastructure. Grand infrastructure goals are what a planned economy like China does best. While the world awaits the details of the PRC’s 14th Five Year Plan, you can bet HOLI will be busy servicing Chinese needs for high-speed rail and subway transit.
  3. Limited Domestic Competition: While large multinationals account for the majority of global automation market share, to the extent this is true in China does not extend to the verticals in which Hollysys makes most of its profits. Specifically, the high barriers to entry for servicing nuclear power plants and high-speed rail gives the company an enviable moat around a significant portion of its revenue share.
Currently, HOLI’s sustainable competitive advantage comes from its specialized offerings of high-speed rail signaling systems to ensure the safety of passenger train movement. The China Train Control System (CTCS) is a country specific high-speed rail standard and therefore is different from international standards propounded by European organizations or Japan. This barrier to entry makes HOLI the largest provider in a growing market. In fact, their 39% market share from 2015-2018 for total automatic train protection (ATP) sets sold made them the largest Chinese company in the domestic automation market. 

Rail is also the division in which the company has its highest profit margins.
HOLI’s revenue comes from three main offerings: IA, Rail, and M&E. Historically, the revenue share between the three divisions has been very stable: 40%, 36%, and 23%, respectively. In 2019 and 2018, the company had a GP% of 37% and 38%. Over those two years, IA posted a GP% of 41% and 40% while Rail posted a GP% of 48% and 52%. M&E were by far its lowest margin operations with a GP% of 13% both years. The company does not provide revenue figures by geographical area for each division, but it does break out total revenues by geographical area. We can infer from this breakout and from other financial and marketing materials that almost all IA and Rail revenue is derived from business in the PRC while M&E revenue is generated from its foreign subsidiaries in Singapore, Malaysia, and the Middle East.

China’s high-speed railway operating mileage, currently the largest in the world, has grown from 19,000km in 2016 to 32,000km at the end of 2019, covering 80% of China’s major cities and surpassing the 30,000km goal by 2020 laid out under the 13th Five Year Plan. Though the details of infrastructure goals won’t be released until the next five year plan in 2021, high-speed rail is expected to be at least a $4.4 billion industry by 2023, with maintenance and replacement accounting for a rapidly growing share of expenditures. Higher growth is expected in the urban rail transit sector, which is expected to grow from 5,500km to 9,276km by 2023. In general, infrastructure needs are driven by the rapid urbanization and regional economic integration and is supported by ambitious policies such as the five year plans, Eight Horizontal and Eight Vertical High-speed Railway Corridors project, and the Belt and Road Initiatives. With its leading market share in these industries, HOLI is well positioned to take advantage of this growth. ­

China’s industrial automation market is similarly poised for accelerated growth. Total contract amount from industrial automation in China grew at a 4.9% compound annual growth rate (CAGR) from 2014 to 2018 and reached a total value of $30.1 billion. The market is estimated to accelerate that growth to 11.1% CAGR from 2018 to 2023 and reach $50.6 billion. Over that same time, petrochemicals and power are expected to grow at CAGRs of 14.5% and 5.8%, respectively. While competition in the industrial automation market is stiffer, HOLI’s roots in automation for power and petrochemicals, growing name brand recognition in China, advanced technology, and cash-rich position give it a good position to increase its market share. Importantly, HOLI has a unique advantage when it comes to nuclear power.

The 2011 Fukushima nuclear disaster threw a major wrench into China’s plans for nuclear power. To reassure the population that the country was not a risk of a similar catastrophe, the PRC placed a moratorium on the construction of new power plants. After lifting that ban in 2019, the country has 47 nuclear reactors in commercial operation, with twelve more under constructions and more on the way. The impetus for nuclear power in China has increased due to air pollution from coal-fired plants and as a result the country has subsidized nuclear power with an aim to match and surpass the world average of 15% for total electricity generated by nuclear power (currently at 4.75%). HOLI is the only qualified local automation and control product provider to the non-safety control for nuclear power stations. In the nuclear automation segment, HOLI competes with multi-national corporations such as Siemens, Areva, and Invensys, but with the abnormal glut in demand created by the Fukushima disaster HOLI has a prime opportunity to increase its market share.

The M&E division offers solutions through Concord and Bond Groups, two subsidiaries acquired by HOLI in 2011 and 2013, respectively, in Southeast Asia, the Middle East, and Hong Kong. While this division has the lowest revenue and profit margins in relation to the company’s other operations, it also offers its greatest opportunity for business expansion and diversification. A 2019 partnering with the London engineering consulting firm Arup signals a willingness to expand the M&E offerings, potentially through more acquisitions. While profitable, the revenues generated by this division do not significantly affect our valuation of the company. Barring any interesting acquisitions, the only growth we forecast for M&E is over the long-term.

An important measure in our valuation comes from HOLI’s dedication to research and development. Historically, the company spends 6-7% of revenue on R&D, and 40%, or 1,500 employees, of the 3,200 person company work in R&D. Their proprietary technology is at the center of their rail and power offerings – as of June 30, 2019, HOLI held 221 software copyrights, 126 authorized patents, 64 pending patent applications, and 44 registered trademarks. The Chairman and CEO, Shao Baiqing, has been with the company for more than 25 years starting as one of the founding engineers, and “is widely regarded as an industry leader with significant influence in China.”

Despite the fact that EBITDA has grown over 60% since FY17, HOLI has an EV/EBITDA 3.5x. This is both well below the historical multiple for the company and far below its competitors. Taking into account the growing industrial automation and high-speed transit sectors in China, while accounting for some slowdown in infrastructure spending in the current year as the window of the 12th Five Year Plan is closing having already surpassed expected rail mileage, a conservative estimate of future 5% revenue growth rate YoY is appropriate. I see no reason for net income growth to lag behind this rate. Using consistent conservative estimates I arrive at a fair value of $25 per share, close to a 60% discount rate.

  • Corona virus may mutate and spread, slowing business and further depressing Chinese stock values for an unknown amount of time.
  • Escalations by either the U.S. or China in their trade war could negatively affect trade relations or may cause further slowdowns in Chinese economic growth and depreciation of the RMB. This has the potential to adversely impact HOLI’s supply chain for its products and stifle the demand for capital projects and domestic investment in China.
  • The Beijing and Hangzhou subsidiaries of Hollysys are recognized as high and new technology enterprises, or HNTEs, by the PRC government, which entitle each of them to a reduced income tax rate of 15% (compared to the statutory income tax rate of 25%). Additionally, HOLI received VAT refunds and government subsidies of $33 million in FY2019. If the HNTE status is not renewed for those subsidiaries, or the PRC stops recognizing HOLI as a qualified research and development enterprise deserving of VAT refunds, the result could have a material adverse effect on future operations.  

Edit 02/14/2020: In response to a reproduction of this report I posted on r/securityanalysis, I received a comment asking if I had any thoughts on this 2011 post and have reproduced my response below:

A few. After tumbling down the rabbit hole of Australian fund managers, I've come away with the impression that the author, John Hempton, is known for his loud and well-timed shorts – it's worth noting that Bronte Capital's most popular fund posts solid returns while billing itself as both a long-short investment vehicle. The benefit to calling BS on a company's stock is that you get to claim you're right even when you're wrong – search for "Tesla short" and drink every time you read the word "cult." The downside is the time factor in the value equation has a much heavier weighting.  The stock price fell to $5.43 in November of 2011 and didn't permanently get back above Hempton's price of ~$8.80 until August of the next year (coinciding with -25% decline in the Shanghai Composite). The stock then rose ~100% percent over the next two years and since its $25 peak in January of 2015 has only dipped below $15 for one month (Oct. '19). So, was he right?

To quickly address his three core arguments:
  • His accusation that – for whatever reason – Hollysys was fudging their PP&E figures was based on assumptions as misguided then as they are today.  The company has never claimed to manufacture its circuit boards; as previously stated, they outsource manufacturing and assemble their boards in their Beijing and Hangzhou facilities.  Based on an albeit limited knowledge of Chinese labor practices, I’m going to assume the opposite: the boards are assembled by hand, not by machine. 
  • I’m going to do myself a favor and not pour over ten year-old balance sheets. Here’s a comment on the post that I agree with:
  • His point on BDO Hong Kong and general corruption in the PRC is well-received.  For what it’s worth, HOLI’s independent auditor for the FY19 20F was Ernst & Young Hua Ming LLP.  Though I doubt the PCAOB, or whatever Chinese version of an independent accounting investigatory body on public reporting, will be dive-bombing Chinese small-caps any time soon, a Big 4 firm is generally going to have more public audit experience than a BDO.  In response to general corruption, I can see how a reading of my HOLI report could be considered credulous.  To be frank, I assume a certain level of corruption in any bid process regardless of the country.  Certainly, a planned economy will have a higher level of corruption when it comes to infrastructure projects.  My modest proposal was that the share price is undervalued based on historical EV/EBITDA multiples and conservative projections of future revenue.  
I don’t fault anyone who’d rather stay away from Chinese small-caps.  You assume a level of risk that should be built into your fair value projections and portfolio management.  But thanks for bringing Hempton’s oeuvre to my attention – I’ll be sure to keep a close eye on his shorts from now on.